Tennessee Valley Authority: Plans to Reduce Debt While Meeting Demand for Power

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

******************************************************************
** This file contains an ASCII representation of the text of a **
** GAO Product. **
** **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced. Tables are included, but **
** may not resemble those in the printed version. **
** **
** Please see the PDF (Portable Document Format) file, when **
** available, for a complete electronic file of the printed **
** document's contents. **
** **
******************************************************************
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

This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
work may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this material
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:

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 [email protected] . 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 [email protected]

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)

GAO's Mission

The Government Accountability Office, the audit, evaluation and
investigative arm of Congress, exists to support Congress in meeting its
constitutional responsibilities and to help improve the performance and
accountability of the federal government for the American people. GAO
examines the use of public funds; evaluates federal programs and policies;
and provides analyses, recommendations, and other assistance to help
Congress make informed oversight, policy, and funding decisions. GAO's
commitment to good government is reflected in its core values of
accountability, integrity, and reliability.

Obtaining Copies of GAO Reports and Testimony

The fastest and easiest way to obtain copies of GAO documents at no cost
is through GAO's Web site ( www.gao.gov ). Each weekday, GAO posts newly
released reports, testimony, and correspondence on its Web site. To have
GAO e-mail you a list of newly posted products every afternoon, go to
www.gao.gov and select "Subscribe to Updates."

Order by Mail or Phone

The first copy of each printed report is free. Additional copies are $2
each. A check or money order should be made out to the Superintendent of
Documents. GAO also accepts VISA and Mastercard. Orders for 100 or more
copies mailed to a single address are discounted 25 percent. Orders should
be sent to:

U.S. Government Accountability Office 441 G Street NW, Room LM Washington,
D.C. 20548

To order by Phone: Voice: (202) 512-6000 TDD: (202) 512-2537 Fax: (202)
512-6061

To Report Fraud, Waste, and Abuse in Federal Programs

Contact:

Web site: www.gao.gov/fraudnet/fraudnet.htm E-mail: [email protected]
Automated answering system: (800) 424-5454 or (202) 512-7470

Congressional Relations

Gloria Jarmon, Managing Director, [email protected] (202) 512-4400 U.S.
Government Accountability Office, 441 G Street NW, Room 7125 Washington,
D.C. 20548

Public Affairs

Paul Anderson, Managing Director, [email protected] (202) 512-4800 U.S.
Government Accountability Office, 441 G Street NW, Room 7149 Washington,
D.C. 20548

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

To view the full product, including the scope

and methodology, click on the link above.

For more information, contact Robert E. Martin at (202) 512-6131 or
[email protected].

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. ***